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If you try to read the jargon that a lot of analysts write, you get to see the quintessential usage of terms like EV/EBITDA, SOTP etc. There has been a debate as to whether P/E is a good barometer of valuation or whether analysts need to look at other approaches to valuing companies. One such measure is the EV/EBITDA. Let us first break up the formula for simplicity.

Enterprise Value (EV) is the amount you will have to pay to acquire the company and can be effectively expressed as (Market cap + market value of debt – cash balances).

EBITDA, as is well known, represents the earnings of the company before interest, depreciation and taxes. It just considers the operating profits of the company without even providing for capital replenishment.

The EV/EBITDA, therefore, looks at the ratio of what you need to pay to acquire a company as a proportion of what the company’s core operations are earning.

Limitations of the traditional P/E approach

Most investors tend to use P/E as a benchmark for valuations. For example, a P/E of 10X is considered to be attractive and a P/E of 30X is considered steep. But P/E as a measure has certain limitations.

Firstly, P/E ratio is an outcome of market perception. While P/E ratio is calculated as Price/EPS, actually the market determines the P/E ratio to be attributed for a stock and the price is just the result of that.

P/E Ratio by itself does not convey much unless it is also looked at with reference to growth. Here is where the dichotomy comes in. To calculate growth, past growth may be more reliable but has limited analytical value. The moment you shift to future growth, the issue of individual bias comes in.

P/E only considers the equity aspect and not the debt capital, although they are equally important stakeholders. It just considers net profit as the residual income generated for equity shareholders.

P/E can be tricky for loss-making companies and cyclical companies. Take the case of metals. When the metal cycle moves down, most steel and aluminum companies make losses as their costs are fixed. The question is; what to consider as a representative P/E ratio for the company? This is a major shortcoming of the P/E approach.

We have already seen the concept of EV/EBITDA earlier. What the ratio represents is the payback period of a company acquisition. For example, when you acquire a company, you pay the market value of the equity and the debt and receive the cash in the books of the company. In return, you get a running business that is generating positive EBITDA. The ratio of EV / EBITDA, therefore, becomes a measure of your payback ratio; i.e. the number of years you will need to earn back the sum paid for the company in the form of operating profits. The role of market perception is much lesser in the case of EV/EBITDA.

P/E is a good measure for the equity value of the company since it considers the residual profit (EPS) as the denominator. For a running business in a stable industry, the P/E ratio can be a good measure. But P/E cannot help in corporate finance decisions like expansions, diversifications, mergers and acquisitions. In such cases, it is EV/EBITDA that is more meaningful.

P/E ratio works well in the case of manufacturing companies and where the business model is matured. EV/EBITDA works better in case of service companies and where the gestation is too long. For example, capital intensive sectors like telecom and sunrise sectors like Fintech, E-commerce can better use of EV/EBITDA as a measure of valuation.

The thumb rule is that a company with a lower EV/EBITDA is more attractive. The condition is that the debt should not be high-cost debt and the equity must be fairly valued in the market. Also, the EBITDA margins should be predictable. The P/E ratio has to be linked to growth rate. A company with higher growth can justify higher P/E ratios.

Also in the case of cyclical industries like metals and capital goods, the EV/EBITDA can be a better measure as the leverage and net profits are more vulnerable to business cycles and financial solvency. In such cases, the P/E becomes hard to standardize and actually gives absurd results during the peaks and troughs of the cycle.

Of course, one must concede that P/E is a lot simpler and more elegant. The complexity with EV/EBITDA is that market value of debt can be difficult to estimate, especially in a volatile interest rate environment. But for more serious corporate finance decisions, EV/EBITDA is surely a value addition.

Disclaimer: The above opinion is that of Mr. Jyoti Roy (DVP – Research - Angel Broking) & is for reference only.